A version of this testimony was given to the Texas Senate Committee on Finance on May 4, 2022.
Chair Huffman and members of the committee:
Thank you for the opportunity to offer our brief perspective on the three interim charges before you today as they pertain to the state’s public pensions.
My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. Our work in Texas includes actuarial modeling and technical analysis related to the state’s most recent and impactful reforms, Senate Bill 12 of 2019 and SB 321 of 2021. These public pension reforms represent critical initial steps toward making the state’s pension systems as strong and effective as possible.
Increasing contributions to the Teacher Retirement System of Texas (TRS) and modernizing the Employees Retirement System of Texas (ERS) benefit have taken two public pension systems that were on a financially unsustainable path and have redirected them toward long-term solvency. However, the interim charges being discussed today show us there is still an opportunity to improve on how the state and taxpayers offer retirement security to public employees. These improvements can be secured without taking on the risks of unfunded liabilities and surprise cost overruns borne by taxpayers.
Between 2000 and 2019, ERS went from having an $867 million surplus to having $14.7 billion in unfunded pension obligations. By 2019, 64% of new hires under 35 were expected to leave public employment within five years, forfeiting their contributions made on their behalf by their ERS employer. Only 14% were expected to reach a full-career, un-reduced retirement benefit. For many years the state contributed a fixed percentage of payroll toward ERS that fell far short of what actuaries calculated was necessary every year to properly fund the plan. Worse, investment markets also shifted away from high-yielding fixed assets over that period, with many public pension systems opting to increasingly rely on less transparent—and generally higher risk—alternative asset investments to achieve expected returns.
In short, Texas was structurally underfunding a retirement plan designed to address a shrinking cohort of public employees’ needs while taking on more investment risk in an unsuccessful effort to stop the problem.
During the 2021 regular session, Senate Bill 321 tackled these problems head-on. It established a debt payoff plan and a date for when all ERS’ unfunded liabilities must be fully funded. It also provided a new, risk-managed retirement option for new hires that will help ensure that state workers of the past, present, and future can rely on a strong and sustainable ERS system. These solutions also minimize taxpayer exposure to severe long-term financial risks.
Unfortunately, many of the elements that plagued ERS at that time continue to plague TRS today. Although additional state contributions and historic market returns have improved the fiscal posture of TRS on paper, outdated assumptions, funding policies, and benefit offerings make it less likely that the increased contribution levels set by SB 12 in 2019 will ever fully fund all earned benefits going forward or meet the needs of modern educators.
Actuaries advising the TRS board recently warned members about a critical element underpinning the future solvency of the system that needs updating: the current 7.25% investment return assumption. By showing how TRS uses one of the highest investment return assumptions among major public systems—the national average has fallen to 7% over the years, with major plans like CalPERS now lowering assumptions into the 6-7% range—plan actuaries offered legislators a hint of what is in store for the retirement system over the next two decades. Investment revenue is expected to underperform in the next decade relative to expectations, which combined with contribution rates being artificially capped through statute creates the conditions for unfunded liabilities to steadily accrue over the next decade—just as it has done over the last two.
Obviously, lowering investment revenue expectations will mean actuarial cost projections will reveal previously unrecognized costs. Other states have used surplus funds or large investment gains to cover the actuarial cost of using a lower investment return assumption to avoid accruing debt. That method of minimizing risk may be particularly interesting to lawmakers looking for ways to effectively use supplemental surplus revenue without growing government, as well as retirees who depend on the plan being on the path to full funding in order to receive a cost-of-living adjustment (COLA).
Our team will be sharing actuarial modeling throughout the legislative interim that covers both ERS and TRS, highlighting areas of opportunity from a technical perspective. We hope this will help facilitate productive dialogue among stakeholders.
Finally, nearly every lawmaker has heard at least one call for Texas to invest in or divest from one particular asset or another. Sometimes—like the recent calls by some pension systems to divest from Russian companies in the wake of the Ukraine invasion—geopolitics and other national security concerns may dictate certain shifts in investment strategy. Most investment or divestment calls, however, do not involve national security, but rather narrow political interests of various factions.
The impact investment returns have on both the cost and effectiveness of retirement benefits makes placing political constraints on pension fund investments a dangerous proposition. Not only does it make the goal of fully funding earned pension benefits harder for administrators, but it rarely achieves the intended political impact. Instead of preferential treatment for certain industries, an across-the-board update of the rules and expectations set for public pension fiduciaries and enhanced reporting requirements would improve governance and give stakeholders even more confidence in their system for future generations.
The Texas state legislature has been a national leader in updating public retirement design options that empower public employees to choose the best retirement path for themselves and their families. But there is more work to do. We look forward to following up with more technical analysis and exploring these issues in greater detail throughout the interim.
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